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The Fed’s stock valuation issue

By Dr. Don Taylor · Bankrate.com
Friday, July 18, 2014
Posted: 2 pm ET

Federal Reserve Chair Janet Yellen addressed the Senate Banking Committee last week in the Fed's semiannual report to Congress. What moved markets was her comments on sectors of the U.S. stock market that the Fed considers stretched.

Quoting from the Fed's Monetary Policy Report, "Valuation metrics in some sectors do appear substantially stretched -- particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year."

© BRENDAN MCDERMID/Reuters/Corbis

The Wall Street Journal's Money Beat blog spotted a difference in the report, just two pages later, which expanded the stretched valuation to include small-cap stocks. The report said, "Equity valuations of smaller firms as well as social media and biotechnology firms appear to be stretched, with ratios of prices to forward earnings remaining high relative to historical norms."

But it was the social media and biotechnology firms that saw downward price pressure in the stock market.

Even former Fed Chair Alan Greenspan's 1996 "irrational exuberance" comments wasn't this direct about stock market valuation.

At the time, he said:"How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy.

"But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy," Greenspan said.

The bull market in stocks continued for another three years after that comment.

In the wake of Chair Yellen's comments, there's been discussion about the appropriateness of a Fed leader opining on domestic stock market valuations, especially in specific sectors of the market. I'm writing this before she addresses Congress, where she may address her comments to the Senate and the Monetary Policy Report.

I'm going to take a different tack. In an earlier blog post, I wrote about how Fed policy was forcing investors into higher risk assets by keeping short-term interest rates low. The Fed, through quantitative easing and a targeted federal funds rate of zero to 0.25 percent, created the bid in the market for stocks. While dividend-paying stocks were the choice of income-oriented investors, the stock market as a whole benefited from this movement into higher risk assets.

The Fed created this valuation problem through monetary-policy decisions that kept the market awash in liquidity, now five years after the domestic economy was officially declared out of recession in June 2009 and starting to expand by the National Bureau of Economic Research Business Cycle Dating Committee's September 2010 announcement.

How the Fed's decision to end its QE program, expected to take place in 2014, will influence the stock market is uncertain. After all, the Fed isn't tightening. It's just not continuing to put more liquidity into the market by continuing to purchase Treasury and mortgage backed securities.

What do you think? Should the chairman of the Federal Reserve Board opine on stock market valuations by sector?

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